The Benefits and Mechanics of Uncapped Convertible Notes

Uncapped convertible notes are a popular funding option for startups, offering a flexible way to raise capital without giving up equity. They can be used to raise up to $10 million or more.

One of the key benefits of uncapped convertible notes is that they don't require a valuation cap, which means the investor can convert their note into equity at a later date without any restrictions on the valuation of the company. This provides more flexibility for the company to grow and scale.

Uncapped convertible notes typically have a maturity date, after which the investor can convert their note into equity or receive a return of principal. The interest rate on an uncapped convertible note can be as high as 10% or more, depending on the terms negotiated.

Investors who use uncapped convertible notes often include venture capitalists, angel investors, and family offices, who are looking for a flexible and low-risk way to invest in startups.

Uncapped convertible notes can be a great way to raise capital without giving up too much ownership. This type of financing allows companies to defer conversion until shares are potentially worth more, reducing equity dilution.

Companies can issue convertible notes faster and cheaper than traditional equity financing, making it attractive for early-stage companies with limited credit history or successful track record raising capital. This type of funding can also be used as a form of bridge financing for more mature companies.

The terms of a convertible note can vary, but typically include conversion privileges and a callable option. For example, ABC Company's convertible debt financing allowed the investor to convert into 20,000 common shares at $50 per share within 3 years, with a monthly interest rate of 4% until then.

Here are some key financial aspects to consider:

In some cases, convertible notes can cause higher dilutions for founders if the company is unable to raise larger capital in future rounds. However, Accel Atoms offers an uncapped convertible with no valuation limit or discounts, supporting founders in sharing equity at fair market valuation.

Companies can take on convertible debt to reduce equity dilution, allowing them to raise funds without giving up too much ownership.

By issuing convertible debt, a business can defer conversion until its shares increase in value, reducing the number of shares that need to be sold. For example, if a business wants to raise $1 million and its shares are worth $20, it can issue only 33,333 shares instead of 50,000 shares.

Convertible debt can be easier to issue than equity investment because it doesn't require changes to the company's shareholder agreement.

This type of funding is especially attractive for early-stage companies that may not have a successful track record raising capital. It's often faster and cheaper than traditional equity financing.

Convertible debt can also be used as a form of bridge financing, which can be appealing to more mature companies under certain circumstances.

Convertible debt can appear in a balance sheet in a way that might seem confusing, but it's actually quite straightforward. In the event of a sale or liquidation, debt always ranks ahead of equity, so debtholders are first in line to be paid.

The security of convertible debt can be viewed as either debt or equity, which affects its ranking in the payout order. Bank debt typically ranks ahead of convertible debt, which in turn ranks ahead of preferred shares.

For traditional banks, subordinated convertible debt is treated as equity. On the other hand, for general preferred shareholders, convertible debt is viewed more like debt because it ranks ahead of their investments in the payout order.

In the case of ABC Company, their convertible debt was listed as a non-current liability before being converted into shares. After the conversion, it appeared under shareholders' equity.

Here's a simple breakdown of how convertible debt is ranked in a balance sheet:

This ranking can affect how convertible debt is treated in a balance sheet, as seen in the example of ABC Company's balance sheet.

A valuation cap on convertible debt can be a crucial factor in determining the ultimate investment in a company. This cap sets a limit on the value at which the debt can be converted, giving lenders more certainty on their investment.

Lenders may ask for a valuation cap to be included in the convertible note, as seen in Example 1, where a company taking out a $5 million convertible debt loan may be asked to cap the conversion value at $40 million.

This cap can benefit lenders, as seen in Example 1, where a lender may receive equity at a 20% discount to the valuation of the round.

A valuation cap can also provide more favorable terms for lenders, as they will have more control over the conversion of their debt into equity.

Here are some key points to consider when it comes to valuation caps:

It's essential to understand the implications of a valuation cap on convertible debt and how it can impact your company's future fundraising efforts.

Convertible Notes create more dilution due to accrued interest, but have advantages in a shutdown or company liquidation, where they have the first claim to the company's assets.

In a shutdown, Convertible Note investors might recover some of their principal, whereas SAFE Note and priced equity investors would get nothing.

Convertible Notes can act as "mini-bridge loans" between priced rounds, which is rare for SAFE Notes.

Priced equity rounds have become simpler and cheaper to execute, making them a more attractive option for startups.

Convertible Notes are more favorable to investors due to their maturity and full repayment, but from the co-founders' perspective, they usually mean more dilution.

Priced equity rounds are still superior in most cases, and if a startup needs a bridge loan, Venture Debt could work quite well.

Convertible Notes and SAFE Notes should be considered secondary options, not top priorities when considering startup funding options.

Calculating ownership in an uncapped convertible note can get tricky, especially when it comes to determining the number of shares that Convertible Notes convert into.

The Seed Investors got their shares "for free" in the Series A round, which means they own less than 33% of the company, even though the Series A investors own more than 33%.

This discrepancy can lead to a higher "true" pre-money valuation, which can affect the ownership percentages of all parties involved.

In some cases, people use the "Dollars Invested" method to determine the number of shares that Convertible Notes convert into, which can produce a lower "true" pre-money valuation.

This method subtracts some of the Convertible Note, resulting in both the Convertible Note and Series A investors having higher ownership percentages, and the Co-Founders getting more heavily diluted.

Convertible Notes can create more dilution due to accrued interest, but they have advantages in a shutdown or company liquidation, where they have a clear place in the capital structure and can recover some of their principal.

Convertible Notes are more favorable to investors due to their maturity and full repayment, varied conversion triggers, accrued interest, and seniority.

However, from the co-founders' perspective, Convertible Notes usually mean more dilution and don't necessarily provide a big benefit unless the company shuts down.

Priced equity rounds have become simpler and cheaper to execute, and they don't create messy cap tables, unclear valuations, or accrued interest with higher dilution.

Convertible Notes and SAFE Notes should be in the "Interesting and good to know, but not necessarily a top priority" category when you're considering startup funding options.

In some cases, Convertible Notes can act as "mini-bridge loans" between priced rounds, which is rare for SAFE Notes.